Risks and Opportunities in a Fragmenting World

2014 will end up in the history books as a surprisingly good year for US stocks and bonds. Though the S&P 500 index was showing a decline on the year through early October, the Federal Reserve’s (Fed’s) reassurance that it would be “patient” in raising short-term interest rates reinforced a sharp rally over the last two months of last year. The result was a year to date gain of over 10%. A move of that magnitude over such a short period of time has only been seen on three occasions since 2000.

Defying consensus, long-term Treasury yields declined further and ended the year lower than they started, despite the momentum in economic growth, robust gains in employment levels and the expectation that the Fed would move closer to normalizing monetary policy sooner rather than later. With most other asset classes at best registering low to mid single-digit gains, thoughtful diversification beyond a simple “plain vanilla” US stocks and bonds portfolio was not needed in 2014, despite the hiccups at the start of the year and during the early Fall.

Yet that conclusion ignores two important stories that unfolded in the currency and commodity markets late last year. Both have profound implications for investors in the early half of 2015.

Firstly, the US dollar’s exchange value across almost all foreign currencies surged, in many cases to multi-year highs.

The strength in the US dollar can partly be explained by the Fed conditioning the world to expect an end to five years of abnormally low interest rates. Having ended their program of buying bonds to drive down interest rates in October as scheduled, they signaled clearly to expect short-term interest rates to “lift off” when the data confirms a healing labor market and when inflation begins to trend higher and closer to its 2% target.

More significantly, elsewhere in the world central banks including the Bank of Japan, the European Central Bank and People’s Bank of China took further steps towards driving down their interest rates in an effort to combat deflation and weakening economies. This created strong demand for “safe” US Treasury bonds, especially with the tailwind of further currency gains from the expectation of continued strength in the US dollar. The solid returns from US fixed income in 2014 and the bulwark they continue to provide during sudden periods of market duress highlight again why we maintain an allocation to Safe¹ assets across our strategies, albeit at the low end of our ranges and with a strong focus on managing interest rate sensitivity.

It is not clear if the Fed’s doctrine for combating deflation will work abroad as well as it appears to have worked in the US. In Europe, bond markets are not as deep or liquid as in the US and concerns over the legality of buying sovereign bonds mean that the European Central Bank does not have as many tools at their disposal as the Fed did. The Bank of Japan appears to have all the necessary tools, but the key to success there lies in policymakers ensuring there is finally sufficient political will to sustain the policies and reforms that have been dubbed “Abenomics” after Prime Minister Shinzo Abe.

After two decades of many false dawns, Abe and Bank of Japan Governor Haruhiko Kuroda are demonstrating impressive resolve in implementing coordinated monetary and fiscal policy. By boosting demand, they are setting the stage for more important structural reforms, including a new focus on corporations maximizing shareholder value and return on equity.

We moved to capitalize on the fragmenting opportunity set within Market Risk during 2014, and this decision appears to be paying off so far in 2015.

Secondly, the correction in the price of crude oil turned into an epic crash. Let’s explore the causes and potential consequences of each.

Last quarter’s second big story was of course the precipitous oil price crash. By the end of the year, prices of various crude oil benchmarks had halved. Speculation has been rife that the start of the decline in oil price was engineered as a geopolitical plot to put pressure on the likes of Russia, Iran and the terror group ISIS, all of whom depend on oil revenues for funding. Yet, that exciting narrative masks the fact that for some time now, changing supply and demand fundamentals have been putting pressure on the price of oil to decline. On the supply side, increases in production from the US “fracking” revolution and Libya have consistently exceeded expectations. On the demand side, gains in efficiency where oil is an input for production and increasingly commercially viable alternative fuels have emerged against a sluggish global economy (outside of the US).

When the oil cartel OPEC refused to shore up the declining fall, it was the perfect recipe for the correction to turn into a sudden rout. “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could,” the famous economist Rudi Dornbusch has commented on the well-documented tendency for asset markets to overshoot fundamental fair value. In such instances, it rarely pays to attempt to time “a top”—or in this instance “a bottom”—perfectly. The oil price will eventually regain its footing at its new long-run fair value once marginal producers have been squeezed out and supply falls to clear demand again. In our view, there will be lots of time and plenty of opportunity to invest across a broad range of asset classes that has been unfairly marked down in the process as the second and third order consequences of the oil price crash become evident. We had no direct exposure to the oil price capitulation across our strategies.

Looking Ahead

As the consequences of the U.S. dollar’s strength and oil price collapse reverberate, economic data may register more volatility over the next few months. Despite continued employment gains, continued subdued wage growth and lower than comfortable inflation readings may mean the Fed keeps short-term interest rates lower for slightly longer than many anticipated a few months ago. This in turn may allow room for risk assets in general and US markets in particular to rally further once it is clear that the oil price has bottomed.

Our 2015 Capital Markets Forecast comprehensively updates our outlook over the next market cycle from today’s starting point. The diverging paths of global monetary policy and the reverberations of the oil price collapse reinforce several of its conclusions:

  1. Safe assets today offer primarily a bulwark to strategies when risk assets suffer duress, especially over short horizons. At such low levels of starting yields, the additional duration and credit risk taken to boost the building block’s secondary income generation role needs to be assessed very carefully.
  2. Within Market Risk there are clear but selective opportunities that may develop further in international equity markets. Those assuming US equity valuations can stay elevated via a lower equity risk premium if fixed income rates were to rise do not have the historical evidence on their side. US corporate profits as a percentage of GDP are now just under 10%, the best in history, compared to a long-run average of 6% since 1929.²
  3. We conclude that in today’s environment, Manager Skill can be additive to certain strategies in a specialist defensive role, if it is able to provide protection beyond what an allocation to Safe can deliver during times of Market Risk duress.

Over the last two years we have maintained our discipline that has served our clients well over several market cycles: focusing on protecting their capital in downturns and optimizing returns so that they maximize the probability of reaching their goals. As we make our way through the first quarter of 2015, markets are finally experiencing a more sustained spate of volatility and a changing environment with new opportunities to capitalize on and different risks to mitigate. We will continue to strive to strike the appropriate balance between the two.

¹ No inference that “Safe” assets cannot fall in value.
² Source: GMO LLC

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